(a)        How much equity must the project investors contribute to the project?

All projects require a portion of the total project costs to be borne by the project investors. The project investors contribute by way of true equity (i.e. share capital) and subordinated debt (provision of loans or subscription for loan notes). The “gearing ratio” (or debt to equity ratio as it is also called) tests the proportion of debt in the project against the amount of equity contributed by the project investors. The required proportion of equity varies by jurisdiction and project. The more risky the project, the higher the requirement for equity e.g. UK PPP is often 90:10; an African infrastructure project is more likely to be 70:30.

(b)        Forms of equity

(i)         Equity can be contributed to a project company in one of two forms: either true equity (paid up share capital) or equity subordinated debt.

(ii)        Paid up share capital is your typical “true equity”. In this form, project investors will receive their return on investment in the form of dividends. This is very common, however, an issue for project investors is that dividends can only be made from realised profits, which means their cash is “trapped” in the project company and cannot be returned to investors or applied toward other investments until a later date.

(iii)       Equity subordinated loans are often preferred by project investors as a way around this issue – as project investors will receive their return on investment in the form of interest on these loans.

(iv)       Subordinated loans will be subordinated to the repayment of senior debt (i.e. the project finance debt from the lenders). Some jurisdictions may have rules on thin capitalisation which restrict a company from being highly leveraged (having more debt than true equity). The rationale behind these rules is that where a company is financed by its shareholders through a mixture of debt and equity and the shareholders have introduced only a nominal amount of paid-up share capital, then the company has lower financial reserves with which to meet its obligations.

(v)        Similarly, certain lenders, such as export credit agencies, may require that at least 50% of equity is “true equity”.

(vi)       The lenders will want security over the project company’s and the project investors’ rights in respect of the equity subordinated loans. This is because in an enforcement scenario, lenders will want to enforce the project investors’ obligations to make payments to the project company which have not yet been made, and will also want to ensure that any amounts to be repaid to the project investors are not distributed until the senior debt has been repaid.

(c)        When is the equity contributed to the project?

This is a question of risk allocation and will be dependent on the project: the technology, the market, the jurisdiction, the project investors.

Project investors generally don’t want to put in their equity upfront, as it affects the return on their investment on the basis of the time value of money. On the other hand, lenders will want to ensure the project investors’ commitment to the project by seeing their equity going in before the lenders lend.

In many transactions, the negotiated position is that equity goes in pro-rata – this will mean that equity and debt will go in at the same time in accordance with the agreed debt to equity ratio. So for example, if a project is going to cost $100, lenders and project investors may agree a debt to equity ratio of 80:20. That will mean that for every $8 of debt that goes in, project investors must ensure there is $2 of equity also injected at all times.

Back ended equity is where equity goes in after debt i.e. at the end of the construction period. This is very unusual.

An equity bridge loan can be used where the project investors want to delay their contribution but the lenders want the contribution to made pro rata or upfront. The structure of an equity bridge loan allows project investors to delay their cash being injected into the project company, but lenders will treat the equity as already having been contributed.

(d)        What are equity bridge loan facilities?

Equity bridge loan facilities are a common way for project investors to inject equity into a project company, but at the same time defer the actual cash outlay required.

The structure works as follows:

(i)         Timing for equity contributions

Project investors agree with the lenders when to inject their equity, either in full prior to first drawdown of the project finance loans or pro-rata with the project finance loans.

(ii)        EBL facilities

Separately, the project investors arrange for this equity to be provided by commercial banks under equity bridge loan facilities. These may be third party banks or banks which are also lenders of the senior loan. The borrower is the project company but the equity bridge lender will benefit from corporate guarantees issued by the project investors (or letters of credit procured by them from a suitably rated bank).

Interest under the equity bridge loan facilities is paid periodically during construction or capitalised (i.e. rolled up to form part of the principal amount), but principal is repaid in a single instalment towards the end of construction using the contribution from the project investors. There may be separate equity bridge hedging arrangements (see below).

(iii)       The funds contributed by the equity bridge lenders are treated as equity for the purposes of the debt-to-equity ratio agreed with the project finance lenders.

(i)         Repayment and hedging

If the interest isn’t capitalised, the funds for paying the interest under the equity bridge loans are typically provided by the project finance lenders (as it is interest paid during construction) and therefore these amounts are included within the overall funding requirements for the project. The project finance lenders may require these amounts to be capped, in which case, the floating rate interest exposure under the equity bridge loan facilities is hedged. Any equity bridge loan hedging is typically provided by the equity bridge lender itself and the counterparty would be the project company, but the equity bridge hedging bank would also benefit from corporate guarantees from the project investors (or letters of credit).

Where there are multiple project investors, there may be more than one equity bridge loan facility and hedging. For example, if there are 2 project investors, there may be 2 equity bridge loan agreements, 2 equity bridge hedging agreements and 4 equity bridge guarantees/letters of credit. The guarantees/letters of credit would typically be on a several (and not joint and several) basis. Alternatively, one equity bridge loan will be arranged with several liability of the project investors, proportionate to their shareholding percentage.

(ii)        Full subordination

The equity bridge lenders and equity bridge hedging banks will be fully subordinated to the project finance lenders. In practice, this means that, after an event of default under the project financing, their claims against the project company can usually be extinguished automatically and their sole recourse is against the project investors under the guarantees (or letters of credit). Prior to an event of default, the project company would typically be entitled to pay the equity bridge lenders’ interest (as noted above, if not capitalised, it would be funded from drawdowns under the project finance loans). The project company should also be entitled to pay principal, although the exact flow of funds in order to discharge the equity bridge loans themselves is usually subject to negotiation – the funds would either be paid direct by project investors to the equity bridge lenders (repayment option 2 in the above diagram) or by project investors to the project company who in turn pays the equity bridge lenders (repayment option 1 in the above diagram) (the former being the better option if permitted under local accounting rules).

(iii)       Once the project investors have discharged the equity bridge loans, an equivalent amount is then converted into share capital and/or subordinated loans.

(b)        Are equity bridge loan facilities common?

Yes, they are standard in some markets.

The structures are popular with bidders since they effectively allow them to defer the obligations to contribute equity. On day one, the equity is contributed by a third party bank and therefore the bidder is not required to make a cash outlay.

(c)        When are dividends paid?

Project investors will be very eager to receive their return on investment. However, lenders will need the project to satisfy certain conditions before they allow distributions to be made. In the context of project financing “distributions” will include both dividends paid on true equity and interest and repayments of principal on the equity subordinated loans. There are typically two layers of restrictions:

(i)         project revenues need to be paid into the proceeds account (an account held in the project company’s name with the account bank) and then make their way through the payment cascade. The payment cascade is a mechanism where revenues must be applied toward project costs, financing costs, repayment of principal, debt service reserve requirements and other fees and expenses first, in an agreed order of priority. If there is cash left over once all these costs have been paid, then project investors will want this leftover cash to be transferred to them (either directly or by payment into a “distributions account”); and

(ii)        the project company will not be permitted to pay any distributions from money in the proceeds or distributions account until certain conditions are satisfied. These would typically include construction completion has occurred; there is no continuing default under the finance documents; all amounts payable under the finance documents have been paid and the project is performing as intended by reference to financial covenants given by the project company.